Simplistically, the equity value of a business is increased when its cash flow stream grows, its outstanding debt is reduced and/or when the valuation multiple applied to its cash flows rises. There are, of course, many different steps a business owner or management team can take to drive improvement in all three of these areas.
After we invest in a family or management-owned company, we have generally found the following to be lucrative initiatives to pursue to increase equity value over time:
- Broaden or Add Key Functional Management
- Reduce Concentrations
- Enhance Throughput and Capacity
- Improve Customer Service
- Upgrade IT Systems
- Develop Succession Plans
Broaden or Add Key Functional Management – We support existing management teams in our investment approach. Often, we have found that businesses are sold in part because they have grown more complex to manage or have opportunities ahead of them that require new skill sets or more depth. In other words, while the existing team may have done a great job growing and developing the businesses up to this point, the team may need additional executives to have the functional skills necessary to drive the business through its next phase. Some of the team may simply need additional training or support. Some of the key functional areas (e.g., sales, finance, IT, logistics, etc.) may need some broader experience through additions to the executive team. Also, as business owners get closer to a sale, we have found that they often defer investments in such key positions. For example, we have seen owners delay expanding their sales forces 1-2 years leading up to a sale given that new salespeople often do not generate a return for the owner for at least that long.
Respectfully and carefully evaluating the current team relative to the strategic growth needs of the company over the next several years is a critical early step to take to create value later. Making sure that the business has the right number of sales people to effectively cover appropriately sized territories, that the CEO is not also acting as the head of sales and the CFO and that the head of IT is more than just a good coder are examples of the kinds of things that we have seen and needed to work with the management team to address. Having good depth of management with the appropriate experience to execute on a growth plan will be noticed by the next buyer of the company as being valuable and lower risk.
Reduce Concentrations – Many family and management-owned businesses have developed strong positions within specific market niches. This focus has often been a source for their success. However, a business that has a significant concentration with its largest customer (or supplier), generates most of its sales from a single product line or that is limited to a narrow geographic territory will be viewed as having higher risk. This will result in a future buyer discounting the future cash flow stream at a higher rate, leading to a lower valuation. Finding ways to grow into other customers, add new product lines or expand the business’ geographic reach will help increase valuation.
Enhance Throughput and Capacity – Any steps taken to improve the business’ ability to produce products more efficiently and with sufficient capacity to meet demands for at least 3-5 years of projected growth will be valued by a future buyer. For example, if a business implements LEAN manufacturing techniques to reduce lead times in production, reduce finished inventory levels and enhance space needs, these benefits can be credibly projected into the future to support improved customer relations, lower working capital needs and lower capital expenditure (or lease) requirements. All of which will support a case of improved cash flows and a higher value.
Additionally, addressing pressing and manageable capacity constraints prior to a sale will not only reduce future capital requirements for a future buyer, but also potentially reduce the perceived risk. For example, adding and successfully commissioning an additional piece of production equipment to expand capacity or reduce bottlenecks will enable a potential buyer to feel more confident in the business’ ability to hit projected financial goals.
Improve Customer Service – Similarly, showing an improving trend for key customer service metrics such as quality, fill rates, lead times and call center wait times, should not only help a future buyer feel more comfortable accepting a set of projections that continues with those trends but also help ensure that key customers provide the business with strong references to other potential customers and buyers when they call during due diligence.
Upgrade IT Systems – The thought of tackling an IT system upgrade often terrifies a family business owner. Making mistakes in implementation or choosing the wrong system can have serious negative impacts on a business. So, they often leave this project for the next buyer. While this may help the family owner sleep better at night, it can have a negative impact on value. However, if an owner can proactively address the IT needs pre-sale, they will incur the costs of implementation, but they may realize some operational benefits from such an upgrade and remove the risk of selling at a slightly lower multiple.
Develop Succession Plans – Many family and management-owned companies have been successful in large part due to such things as the skill and leadership traits of their CEO or the capabilities and strong customer relationships that the head of sales has developed. If these individuals are nearing the end of their careers or wish to move on to a new opportunity after a future sale of the business, the valuation for the company will be enhanced if there is a clear and executable succession plan for them. If there is no one in the company with a demonstrated track record to take their place when they decide to transition, a buyer will very likely see this as a key business risk and adjust value accordingly or, in some cases, not want to pursue a transaction at all.
There are many things a business owner can do to improve the equity value of their business. These are some key things that have successfully generated value within our investments in addition to the straightforward improvement of growing sales and profitability.